Risk Management Techniques: Noninsurance Methods – Useful to consider the classic domino theory

originally stated by H. W. Heinrich

Risk Avoidance
• A conscious decision not to expose oneself or one’s firm to a
particular risk
• Can be said to decrease one’s chance of loss to zero
• A doctor may decide to leave the practice of medicine rather
than contend with the risk of malpractice liability losses
• Risk avoidance is common
Domino Theory
• Employee accidents can be viewed in light of the following
steps
– Heredity and social environment, which cause
persons to act a particular way
– Personal fault, which is the failure of individuals to
respond appropriately in a given situation

– Particularly among those with a strong aversion to – An unsafe act or the existence of a physical hazard
risk
– Accident
• However, avoidance is not always feasible
– Injury
– Or may not even be desirable if it is possible
• Each step can be thought of as a domino that falls, which in
• When risk is avoided, the potential benefits, as well as costs, turn causes the next domino to fall
are given up
– If any of the dominos prior to the final one are
Loss Control removed

• When particular risks cannot be avoided • The injury will not occur

– Actions may often be taken to reduce the losses – Often argued that the emphasis of loss control
associated with them should be on the third domino

• Known as loss control Figure 5-1: Heinrich’s Domino Theory

• The firm or individual is still engaging in operations that give

rise to particular risks

• Involves making conscious decisions regarding the manner

in which those activities will be conducted

Focus of Loss Control

• Some loss control measures are designed primarily to

reduce loss frequency
Types of Loss Control
– Called frequency reduction
• Severity reduction
• Some firms spend considerable funds in an effort to reduce
the frequency of injuries to its workers
 – For example, an auto manufacturer having airbags
installed in the company fleet of automobiles
• The air bags will not prevent accidents from
occurring, but they will reduce the probable injuries
that employees will suffer if an accident does happen
• Separation
– Involves the reduction of the maximum probable loss
associated with some kinds of risks
• Duplication
– Spare parts or supplies are maintained to replace
immediately damaged equipment and/or inventories
Timing of Loss Control
• Pre-loss activities
– Implemented before any losses occur
• Concurrent loss control
– Activities that take place concurrently with losses
• Post-loss activities
– Always have a severity-reduction focus
• One example is trying to salvage damaged
property rather than discard it
Decisions Regarding Loss Control
• A major issue for risk managers
– The decision about how much money to spend on the
various forms of loss control
• In some cases it may be possible to
significantly reduce the exposure to some types of
risk
– But if the cost of doing so is very high
relative to the firm’s financial situation
» The loss control investment
may not be money well spent
– The general rule is that to justify the expenditure
• The expected gains from an investment in
loss control should be at least equal to the expected
costs
Potential Benefits of Loss Control
• Many of the benefits are either readily quantifiable or can be
reasonably estimated
• These may include the reduction or elimination of expenses
associated with the ff:
– Repair or replacement of damaged property
– Income losses due to destruction of property
– Extra costs to maintain operations following a loss
– Adverse liability judgments
– Medical costs to treat injuries
– Income losses due to death or disabilities
• Another potential quantifiable benefit of loss control
– A reduction in the cost of other risk management
techniques used in conjunction with the loss control
• An example is the decrease in insurance
premiums that often accompanies a loss control
investment
• There may be loss control benefits for which a dollar value
cannot be easily estimated
– Examples include
• The reduction in subjective risk that may
accompany lower expected loss frequency and
severity
 • Improved public and employee relations
associated with fewer and less severe losses
Potential Costs of Loss Control
• It is usually easier to estimate the potential costs
• Two obvious cost components are installation and
maintenance expenses
– For example, a sprinkler system will have an initial
cost to install and also will have ongoing expenses
necessary to maintain it in proper working order
• The challenge of cost estimation is often identifying all of
the ongoing expenses
– Also, some of the ongoing cost may merely be
increases in other expenses
Risk Retention
• Involves the assumption of risk
• If a loss occurs, an individual or firm will pay for it out of
whatever funds are available at the time
Planned Versus Unplanned Retention
• Planned retention
– Involves a conscious and deliberate assumption of
recognized risk
– Sometimes occurs because it is the most convenient
risk treatment technique
• Or because there are simply no alternatives
available short of ceasing operations
• Unplanned retention
– When a firm or individual does not recognize that a
risk exists and unwittingly believes that no loss could
occur
– Sometimes occurs even when the existence of a risk
is acknowledged
• If the maximum possible loss associated with
a recognized risk is significantly underestimated
Funded Versus Unfunded Retention
• Many risk retention strategies involve the intention to pay
for losses as they occur
– Without making any funding arrangements in
advance of a loss
• Known as unfunded retention
• Funded retention
– Preloss arrangements are made to ensure that
money is readily available to pay for losses that occur
Funded Retention
• Credit
– May provide some limited opportunities to fund
losses that result from retained risks
– Usually not a viable source of funds for the payment
of large losses
• Unless the risk manager has already
established a line of credit prior to the loss
– The very fact that the loss has
occurred may make it impossible to obtain credit
when needed
• Reserve funds
– Sometimes established to pay for losses arising out
of risks a firm has decided to retain
– When the maximum possible loss is quite large
• A reserve fund may not be appropriate
• Self-insurance
 – If the firm has a group of exposure units large
enough to reduce risk and thereby predict losses
• The establishment of a fund to pay for those
losses is a special form of planned, funded retention
– Will not involve a transfer of risk
– Necessary elements of self-insurance
• Existence of a group of exposure units that is
sufficiently large to enable accurate loss prediction
• Prefunding of expected losses through a fund
specifically designed for that purpose
• Captive insurers
– Combines the techniques of risk retention and risk
transfer
Decisions Regarding Retention: Financial Resources
• A large business can often use risk retention to a greater
extent than can a small firm
– In part because of the large firm’s greater financial
resources
– Thus, losses due to many risks may merely be
absorbed as losses occur, without much advance
planning
• Examples may include pilferage of office
supplies, breakage of windows, burglary of vending
machines
• The following elements from a firm’s financial statements
should be considered when choosing possible retention
levels
– Total assets, total revenues, asset liquidity, cash
flows, working capital, ratio of revenues to net worth,
retained earnings, ratio of total debt to net worth
• Ability to predict losses
– Although a firm may be able to retain the maximum
probable loss associated with a particular risk
• Problems may result if there is considerable
variability in the range of possible losses
• Feasibility of the retention program
– If the decision to retain losses involves advance
funding
• Administrative issues may need to be
considered
– If the risk is likely to result in several losses over time
• There will be administrative expenses
associated with investigating and paying for those
losses
– Administrative issues are of particular concern when
a firm decides to set up a self-insurance or captive
insurer arrangement
Risk Transfer
• Involves payment by one party (the transferor) to another
(the transferee, or risk bearer)
• Transferee agrees to assume a risk that the transferor
desires to escape
Hold-Harmless Agreements
• Provisions inserted into many different kinds of contracts
• Can transfer responsibility for some types of losses to a
party different than the one that would otherwise bear it
• Also known as indemnity agreements
• Intent of these contractual clauses
– To specify the party that will be responsible for
paying for various losses
– Usually, no dollar limit is stated
• Forms of hold-harmless agreements
– Limited form
• Clarifies that all parties are responsible for
liabilities arising from their own actions
– Intermediate form
• Transferee agrees to pay for any losses in
which both the transferee and transferor are jointly
liable
– Broad form
• Requires the transferee to be responsible for
all losses arising out of a particular situation
– Regardless of fault
• Enforcement of hold harmless agreements
– Are not always legally enforceable
– If the transferor is in a superior position to the
transferee with respect to either bargaining power or
knowledge of the factual situation
• Attempt to transfer risk through a hold-
harmless agreement may not be upheld by the
courts
– Particularly true of broad-form hold-
harmless agreements
Incorporation
• The most that an incorporated firm can ever lose is the total
amount of its assets
• Personal assets of the owners cannot be attached to help
pay for business losses
– As can be the case with sole proprietorships and
partnerships
Diversification, Hedging, and Insurance
• Diversification
– Results in the transfer of risk across business units
– Combining businesses or geographic locations in one
firm can even result in a reduction in total risk
• Through the portfolio effect of pooling
individual risks that have different correlations
• Hedging
– Involves the transfer of a speculative risk
– A business transaction in which the risk of price
fluctuations is transferred to a third party
• Which can be either a speculator or another
hedger
• Insurance
– The most widely used form of risk transfer
The Value of Risk Management
• Some elements of risk management can be viewed as
positive net present value projects
• If the expected gains from an investment in loss control
exceed the expected costs associated with that investment
– The project should increase the value of the firm
• However, shareholders in a publicly traded corporation can
eliminate firm-specific risk
– By holding a diversified portfolio of different
company stocks
• Therefore, the shareholder would appear to
care little about the management of nonsystematic
or firm-specific risk
• This would appear to make many risk
management activities negative net present value
projects
 – However, many corporations engage in Integrated Risk Management
a number of activities directed at managing firm-
specific risk • The enterprise view of risk management

» Why is this economically – Encompasses building a structure and a systematic

justified? process for managing all the corporation’s risks

• Mayers and Smith suggest reasons for the transfer of risk by
the corporation
– Insurance contracts and other forms of risk transfer
can allocate risk to those of the firm’s claim holders who
have a comparative advantage in risk bearing
– Risk transfer can provide benefits by lowering the
expected costs of bankruptcy
– Risk transfer increases the likelihood that the firm
will meet its obligations to its debtholders and assures
that funds will be available for future investment in
valuable projects
– The comparative advantage of insurers in providing
services related to risks can be an advantage of risk
transfer through insurance
– When the tax system is progressive
• The additional tax from increases and
earnings is greater than the reduction in taxes
associated with decreases in earnings
• A broader view of risk underpins the movement toward
enterprise risk management
– Considers financial, commodity, credit, legal,
environmental, reputation, and other intangible
exposures that could adversely impact the value of the
corporation
• The formation by some firms of the new position of chief risk
officer (CRO)
– Reflects a realization of the importance of identifying
all risks that could negatively impact the firm
– Suggested responsibilities of the CRO include
• Implementation of a consistent risk
management framework across the organization’s
business areas
• Implementation and management of an
integrated risk management program
– With particular emphasis on
operational risk
• Communication of risk and the integrated risk
management program to stakeholders
• Mitigation and financing of risks

• Reflects the realization that appropriate risk management

must consider the fact that the corporation faces a portfolio
of risks

• Diversification within the portfolio of risks facing the

corporation can alter the firm’s risk profile

• Ignoring these diversification effects by managing the firm’s

many risks independently

– Can lead to an inefficient use of the corporation’s

resources